11 February 2014

Fractional reserve bullion banking and gold bank runs – Frankenstein Free Banking

The bullion banking and inter-BB clearing system described yesterday has a lot in common with free banking, which is "the competitive issue of money by private banks as opposed to the centralised and monopolised issuance of currency under a system of central banking."

That quote comes from George Selgin's 1988 paper The Theory of Free Banking: Money Supply under Competitive Note Issue, which provide a good explanation of it. It is 192 pages however, so I would only recommend it to the most dedicated. I'll do my best to draw out the parts of Selgin's paper relevant to our topic.

The key features of a free banking system as described in Selgin's paper include:
  • no central bank, ie no monopoly of currency issue
  • each bank issues its own branded bank notes
  • banks compete against each other for deposits and loans
  • banks hold physical gold as reserves (not government fiat)
  • people are paid in different branded bank notes and deposit these with their bank
  • banks settle/clear the notes of other banks deposited with them by their clients with gold
  • banks establish a clearinghouse to facilitate inter-bank settlements
For the moment let us leave the question of a central bank and consider the above in terms of what I have described over the past few posts. In the case of bullion banking, while there are no physical gold notes circulating, we can consider unallocated accounts as equivalent of the branded bank note - unallocated is specific to the BB with whom you hold it. The BBs do compete with each other in a light touch regulatory environment, depending on the jurisdiction., and the BBs hold physical gold reserves and settle in physical gold via a clearinghouse.

Note: I'm going to refer to a number of conclusions Selgin comes to in his paper, which he bases on logic and historical evidence of episodes of free banking. I am not a monetary expert but to this lay reader his conclusions seem well argued. Happy for people to disagree with his conclusions but if you haven't bothered to engage with Selgin's work, don't expect me to engage, particularly if you are rasing criticisms he addresses in his paper.

One of the key conclusions that Selgin comes to in his paper is that under free banking the supply (creation) of money only responds to changes in demand for money by people. In other words, central bank created inflation as we know it does not occur and "the value of the monetary unit is stabilized, and events in the money market do not disturb the normal course of production and exchange."

The implication for bullion banking is that, if it operates along free banking lines, then there is no excess unallocated gold created, that is, no "inflation" in gold credit and thus no resulting deflation/fall in the fiat price of gold (eg if there was 10oz vs $10 then the price is $1 per oz; if you double the ounces, then 20oz chases $10, price becomes $0.5 per oz).
The reason for this is that if an individual BB creates/lends too much gold credit (unallocated) then when its clients use/transfer that unallocated to clients with accounts at other BBs, it will result in that BB owing gold to its competitor BBs and they will request physical to settle the growing LPMCL imbalance resulting from that BBs over lending. So all BBs are restricted in their unallocated gold lending to the extent of their physical reserves.

However, Selgin notes that the mathematics of inter-bank clearing mean that if all banks expand credit at the same rate, then there will not be any adverse inter-bank clearing balances between them. He notes only two controls over such collusive (or game theory type response - ie if you are expanding credit, I will/have to as well) behaviour:
  1. The growth in money supply will result in a grow in clearings, which will bring with it a growth in the variability of clearing debits and credit. This will require banks to increase their precautionary reserves, and this increase in reserves constrains money creation.
  2. The redemption of physical gold by the public (ie, the reduction in bank reserves).
For bullion banking, the implications are that inflationary gold credit creation (which would push the fiat price of gold down) is restricted only if there are a few prudent BBs that do not follow their competitors. If not, and all BBs increase at the same rate, there will be inflationary gold credit but it will stabilise at some higher level (than than required by legitimate gold credit demand) due to the variability of clearing issue.

However, we know that central bankers hold gold and lend it to BBs, so we do not have a true free banking system. However, it is also not like a fiat system as gold can't be printed, so it is a half way house with bits from both, or a Frankenstein Free Bullion Banking system.
Selgin notes that with a monopolised currency supply, central banks can create more reserves and "since such expansion is a response to the exogenous actions of the monopoly bank and not to any change in the money-holding behavior of the public, it involves “created” credit and is disequilibrating".
So in our Frankenstein Free Bullion Banking system, the lending of gold to the BBs by a central bank increases the BBs reserves and thus increases the BBs' ability to create more gold credit (unallocated). This inflation in gold supply naturally results in its fiat price falling. If so, why then would a central bank actually sell its precious physical gold if it wanted to manipulate the gold price when it can do so via reserve expansion instead? An answer to this rhetorical question tomorrow.


anand srivastava said...

From the Conclusion of the Paper.

Free banking in a near-perfect form has not existed anywhere since 1845, when the Scottish free banking era was ended by Peel’s Bank Act. Its closest approximations since that time, including the plural note issue systems of Sweden, China, and Canada, which survived into the 20th century, have also been replaced by more monopolistic and restrictive systems based upon central banking. How significant is this? How serious have the actual consequences of governments’ failure to allow free banking been?

The question arises why there has been no instances for a long time, if it was such a good idea.

I think the author is biased regarding the benefits of the free banking proposal.

I would think the major problem with central banks is that they are under the control of politicians. ECB circumvents the problem nicely. I would think Central Bank outside political control is the best form of monetary regulation.

Jesse said...

This is a variation of the errors such as we see in the 'efficient market hypothsis,' ie. free banks will produce no more currency than is necessary.

Jesse said...

I should add that this is not to say that 'free banking' could not be made to work.

It would require independent auditors and strict guidelines on the usual suspects in leverage, etc.

Does the 'Panic of 1907' ring a bell?

This is not to say that I am necessarily in favor of a Central Bank, because they too have repeatedly shown themselves to be susceptible to folly and soft corruptions.

Rather, vigilant regulation and transparency are paramount in any system.

Men, alas, are not angels, and the allure of careerism and 'say for pay' is all too strong in all, but especially those professions that are in the close vicinity to the allure of easy money.

Rusty said...

Gold & Silver

To Stand as money a commodity must:-
1) Be generally accepted as a means of payment for another commodity.
2) Be a means of payment for services.
3) Be a Store of value.
4) Be a standard of deferred payment.
5) Be easily divisible and weighed.
6) Be easily carried and transported.
7) Be hard to counterfeit or produce
8) Have labor embodied in its extraction
Gold fits the above bill better than any other commodity and is vastly superior to fiat money and eBolas. The latter two are no commodity at all.
Fiat money must be forced into existence by the laws of the state and by the threat of coercion by Police, armies, courts, and lawyers.

Note 1: the new kid on the block is of course crypto currency that, similar to gold, must be mined if it is a true crypto currency. This is capital (dead labor intensive) and power consumption intensive. Could it replace commodities such as gold and force 'commodity currency' into the dustbin of history? That is the question.

Note 2: Bankster electronic currency (eBolas) is forced into circulation by the creation of Interest bearing debt. The debt is 'usually' paid down periodically leaving the interest in the banksters hands. There is very little labor required in its creation. It is the interest wherein the labor is extracted.

Bron Suchecki said...

Jesse, your points are valid but to be fair to Selgin, that paper was from 1988, well before the recent corruptions of financial markets we have seen.

I am not across Selgin's recent work or www.freebanking.org to see if they have deal with the regulatory capture and collusion between traders issues.

I certainly would not be comfortable with the idea that a totally free market would be self regulating.